Quiz!
Which of the following is the most promising investment?
- A company that is losing money and is priced low reflecting the losses.
- A profitable company that is underappreciated and priced low.
- A company with phenomenal profitability, that you shop from every day, and can’t live without.
Sales up 27%, Profits up 47%, Stock Down 7%! What Gives?
On 7/29/2021, Amazon reported spectacular Q2 sales growth of 27%. Profits grew even faster, at 47%. Yet, the stock declined 7% after the announcement. This is could be unsettling for investors that chose Amazon, given it’s amazing profitability.
What happened? These growth rates were below prior growth rates and the expectations. Stock prices move in response to changes in the company’s performance – a relative measure, as opposed to the absolute company performance. Once the bar is set very high, gains could be tough to achieve, and declines can be very rapid.
Did we get any warning signs? Yes, glaring ones. It’s P/E (stock price relative to earnings) was 69, and it’s P/B (stock price relative to company value or liquidation value) was 17. These numbers are huge, and reflect a company that is 100%’s better than other companies.
An extra difficulty: Stocks of successful companies sometimes go up far above their intrinsic value. It is partly the result of people choosing a company based on its success or even solely based on recent stock growth, while ignoring the stock price. You can do the same, and do well for some time, as people do in various pyramid schemes, or you can join at the peak and experience steep declines. The peak may come during a phenomenal quarter for the company.
How can you use this information? Whenever analyzing whether to buy a stock, look for companies that are underpriced relative to their performance. These include phenomenal companies that are underappreciated, as well as mediocre companies that are priced too low. If you find a company that you love and believe in, analyze how much of its value is already reflected in the stock price, before investing.
What is the future of Amazon’s stock? This question is outside the scope of this article. There are many positive and negative factors, and it’s not a trivial task to combine them to reach an answer. Here is a sliver of the factors: Will the company manage to revert back to its phenomenal growth of prior quarters, or even beat it? Will enough investors continue to bid up the price because they love the company, or because the stock price went up in recent years? Will competition eat into Amazon’s market share, or will Amazon gain even greater market share? Will interest rates in the US go up, hurting Amazon’s borrowing costs? The full list is very long.
Quiz Answer:
Which of the following is the most promising investment?
- A company that is losing money and is priced low reflecting the losses.
- A profitable company that is underappreciated and priced low. [Correct Answer]
- A company with phenomenal profitability, that you shop from every day, and can’t live without.
Explanations:
- If the company is priced appropriately, the next step is to check the odds of a turnaround towards profitability. Trusting a turnaround can be risky, and should be done with caution, based on strong evidence.
- The combination of profitability & underpricing is the ideal one. Underpriced profitable companies have the potential for extra returns compared to the average company.
- A phenomenally profitable company is a great start. If you can’t live without it, and others feel the same, it’s another positive sign. The missing part is whether the stock price reflects more or less of all these positives.
See article for more explanations.
Disclosures Including Backtested Performance Data